US states move to close carried interest loophole

Private equity group Blackstone has warned investors that it faces a growing risk of significantly higher tax bills because of efforts by US states to end a lucrative tax break that Washington lobbyists have fought hard to preserve.

A California proposal to levy state tax on carried interest — the share of investment profits that hedge fund and private equity managers are paid as an incentive to hit higher returns — faces its second key legislative hurdle this week.

Under federal law, carried interest is taxed as a capital gain, rather than as personal income, enabling hedge fund and private equity executives to pay lower tax rates on some of their earnings than salaried workers. California would eliminate that tax break by levying extra state tax to make up the difference.

The carried interest tax break, worth billions of dollars, has become emblematic of a tax system that campaigners criticise for favouring the rich while many ordinary Americans struggle with rising costs and stagnant incomes. Last year’s sweeping federal tax reform bill did not change the status quo — something that was seen as a victory for industry lobbyists.

Lawmakers in New York — the only state with more hedge fund managers than California — have introduced legislation to curb the tax break, which could raise nearly $1.1bn annually for the state, according to Governor Andrew Cuomo.

To avoid an exodus of fund managers, the proposed New York tax increases would be delayed until similar proposals pass in Connecticut, New Jersey, Massachusetts and Pennsylvania. All told, at least 10 jurisdictions are considering such a move, according to the Hedge Clippers, a group campaigning to end favourable tax treatment of carried interest.

“To some of these states, a few billion dollars is a lot of money,” said Morris Pearl, the chair of the Patriotic Millionaires, which is working with the Hedge Clippers in campaigning in favour of the legislation. “Whereas at the federal level, it doesn’t really move the needle, but it’s just an issue of fairness.”

Blackstone has long told investors that its tax rate “could increase significantly” if it abandoned the partnership structure that allows it to pay less tax on carried interest.

In a regulatory filing earlier this month, it added new language flagging the draft California law and stating that several states were giving “heightened consideration” to a carried interest levy.

Blackstone cited the federal tax cuts signed into law last year by President Donald Trump as the impetus for the state initiatives.

The new federal law cut the tax bills of many wealthy Americans while failing to change the treatment of carried interest, despite its being a loophole Mr Trump criticised for allowing hedge fund and private equity managers to “make a fortune” and “pay no tax”, which he called “ridiculous”.

The American Investment Council, the lobby group for the private equity industry, said it “strongly opposes” proposals that seek to change the tax treatment of carried interest capital gains to ordinary income.

“We also oppose efforts in states to enact punitive additional state taxes on carried interest capital gains,” the group said. “Private equity is responsible for pumping hundreds of billions of dollars into the US economy and strengthening thousands of businesses each year in all 50 states. Raising taxes on carried interest capital gains would remove a key incentive for entrepreneurial risk-taking.”

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The Managed Funds Association, an industry group that represents hedge funds, has spent $27.8m in its lobbying efforts on issues including carried interest since 2007, according to data compiled by Hedge Clippers from Senate lobbying disclosures.

Earlier this month, KKR became the second listed buyout group to scrap its partnership structure and abandon the carried interest tax break voluntarily, betting that it had more to gain from a simpler structure that could lift its share price by generating more demand for its shares.

But the firm’s billionaire founders receive investment income through a separate partnership vehicle that still qualifies for the tax break. This week’s negotiations in California could eventually prove costly for one of them: buyout pioneer George Roberts is based 100 miles away from the state capital, in Menlo Park.